Bitcoin Regulation Update- 02/14/14

The week preceding today’s update saw Bitcoin’s network subjected to adeliberate attack by parties unknown, temporarily halting withdrawals at several exchanges and driving down the price of bitcoin for those bold enough to continue trading. Nevertheless, rumors of Bitcoin’s imminent demise seem to have been exaggerated. Though network strain was obviously an inconvenience to users worldwide, the network neither failed nor broke. Bitcoin’s resiliency in the face of attack is likely to be interpreted in one of two ways, depending on who you ask. Users and potential users may enjoy increased confidence in the safety and security of the distributed peer-to-peer model. Greater trust translates into less volatility during future periods of adverse network conditions. Regulators, on the other hand, could consider close scrutiny of Bitcoin to be even more desirable than previously contemplated, since the network has shown itself to be highly resistant to efforts to shut it down, and can reasonably be expected to become more robust over time. This limits the ability of governments to ban Bitcoin and similar crypto-currencies outright, leaving them with no choice other than detailed rulemaking to monitor and control Bitcoin activity.

As reported last week, many legal marijuana sellers are turning to Bitcoin to mitigate their cash management problems. However, at least one exchange, Coinbase, has refused to process exchange transactions for marijuana dispensaries due to the possibility of federal enforcement action. According to areport carried by Bitcoin Examiner, marijuana entrepreneur Sean Gren of Washington’s Pacific Northwest Medical, has been denied the use of a Coinbase account to convert bitcoin received in connection with medicinal marijuana sales into US dollars. Though the sale of marijuana has been legalized in the states of Washington and Colorado and decriminalized in a number of jurisdictions in other states, it remains a Schedule 1 controlled substance under federal law (Drug Enforcement Administration Schedule 1 includes drugs with known currently accepted medical use). By exchanging bitcoin for establishments that are technically illegal under federal law, Coinbase fears that it could risk losing its money service business license or be subjected to other money laundering related enforcement action by the US Treasury. The risk of running afoul of anti-money laundering rules has reportedly caused precious metals brokers to also shy away from accepting Bitcoin. Nothing stops marijuana dispensaries from continuing to accept bitcoin, but it appears that they may have to develop other ways to liquidate their holdings for the time being.

UPDATE 02/15/14- FinCEN issued a statement on February 14 that, in accordance with enforcement guidance issued by the Department of Justice, it would not consider banks providing services to licensed marijuana dispensaries to be in violation of federal anti-money laundering rules. This opens the door for dispensaries to start using banks for cash deposits and credit card processing, but largely removes the incentive for them to rely on Bitcoin.

The State of New York will adapt money transfer rules for Bitcoin, to include some form of licensing applicable to both exchanges and miners operating there, according tocomments made by state financial services superintendent Benjamin Lawsky at a conference on February 11th. He went on to state that “Bitcoin exchanges should have to warn their customers that virtual transactions are irreversible, bitcoin values are volatile and they should carefully guard their digital wallet keys.” He did not comment on why he believes that exchanges specifically ought to be targeted by proposed “truth in Bitcoining” rules, though it is worth noting that the state currently has none in operation. Lawsky, who took office as New York’s first financial services superintendent in May of 2011, became a public figure while investigating and prosecuting various forms of white collar crime as a special assistant to former Attorney General (now governor) Andrew Cuomo. Regulations developed by the State of New York are likely to have far-reaching impact both as a model for other states to consider when drafting their own rules, and a potential source of legal complications for Bitcoin firms that aren’t physically located in New York, but do business with residents of that state.

Canada’s draft budget for fiscal year 2015includes language calling for increased scrutiny of Bitcoin in the name of combating “emerging risks, including virtual currencies…that threaten Canada’s international leadership in the fight against money laundering and terrorist financing.” The legislative committee responsible for anti-money laundering regulations also proposed an additional appropriation of funds for FINTRAC (the Canadian version of the US Treasury Department’s FinCEN) to use in developing a system to analyze virtual currency transactions. It isn’t difficult to imagine how a fairly modest data mining operation under the control of a law enforcement or tax collection agency could start to peel back the thin veneer of anonymity enjoyed by Bitcoin transactions at present. Whether, and to what extent, Bitcoiners have a reasonable expectation of privacy when it comes to transactions immortalized on the public block chain is likely to be a contentious issue in countries like Canada, where personal privacy is considered a basic right.

Australian technology firm HotwirePE announced the launch ofDenariuz Bank in Australia on Tuesday. Denariuz, which bills itself as the first crypto-currency based bank in the world, is the result of nearly a year of negotiations between its parent company and Australian regulators. How (or if) its business model will differ from a conventional bank is unclear, though representatives have publicly stated that Denariuz would eventually like to offer typical bank products such as checkable accounts, debit cards, time deposits, and loans. Presumably, the bank will pay interest on crypto-currency deposits, which it will then use to make loans at a higher interest rate. The spread, minus the bank’s expenses, will be the bank’s profit. An alternative business model might be one based on trading. Bitcoin deposited in interest bearing accounts would be used for trading on exchanges worldwide for the purpose of generating gains on arbitrage (similar to a conventional money market account). Either way, many Bitcoiners are likely to be suspicious of anything involving fractional reserves. Fractional reserve banking, where depositor funds are “available” for withdrawal at the same time as a substantial portion of them are loaned out or invested, has often been described by crypto-enthusiasts as nothing short of a legalized Ponzi scheme.